Petrocapita Update
May 2010

PerCePtion and reality

It	has	been	said	that	good	investment	requires	the	skill	to	capture	
the	arbitrage	ava...
Summary (continued)

–	 Perception: Government intervention will help maintain growth
	 Reality:	Increasing	the	size	of...
Summary (continued)

	   Given	this,	it	would	seem	a	good	assumption	that	much	of	the	recently	created	money/credit	wil...
Petrocapita Update (continued)

the inflation lag

In	his	book,	“The Dying of Money”	Jens	Parssons	                    ...
Petrocapita Update (continued)

‘Some horrendouS KeyneSian/monetariSt
Petrocapita Update (continued)

painful, not least because it drives up nominal          on discovering that such was t...
Petrocapita Update (continued)

the market goes “no bid”                                                  Who is in Wor...
Petrocapita Update (continued)

picture. The near collapse of financial markets          Interest ate up 44% of the Bri...
Petrocapita Update (continued)

By 2012, surplus oil production capacity could                                         ...
Petrocapita Update (continued)

more on sovereign defaults…
Petrocapita Update (continued)

bondholders beWare?                                                                    ...
Petrocapita Update (continued)

resolutely. Failure to do so will raise the chance of                                  ...
Petrocapita Update (continued)

us farmland returns                                                                    ...
Petrocapita Update (continued)

Average oil prices increased strongly from 2003 to                                     ...
Petrocapita Update (continued)

natural gas plant liquids, and refinery gain) from                                     ...

                                  The	information,	opinions,	estimates,	projections	and	other	materials	
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Petrocapita May 2010

  1. 1. Petrocapita Update May 2010
  2. 2. Summary PerCePtion and reality It has been said that good investment requires the skill to capture the arbitrage available between perception and reality and therefore it is critical to know both. Consider the perception and reality reflected in the following quotes: “In some ways it’s a battle of the politicians against the markets. That’s how I do see it. But I’m determined to win this battle.” Angela Merkel, German Chancellor “How did you go bankrupt? Two ways. Gradually, then suddenly.” Ernest Hemingway Contents I think that there is something emblematic of our current financial predicament in these two snippets of text. With constant fiscal 4 The Inflation Lag deficits the governments of the developed world have so far been 4 Die Leerverkäufer Sind Kaputt gradually bankrupting themselves. Now by stepping in to transfer 4 Developed World Has the Debt private sector debt problems onto already precarious public sector Problem, Can You Believe Less balance sheets I believe they may be moving on to the sudden stage So For the Emerging Markets of bankruptcy – if not de jure then de facto. What Chancellor Merkel 5 ‘Some horrendous Keynesian/ is really saying is that she is unhappy that the market is starting monetarist nightmare’ to see through the false assumption of sovereign solvency and is 5 A Glimpse Into the Financial Hell acting accordingly. of Stagflation 6 QE Update – When is the Here are a few more observations in the category of reality/ Sterlisation Going to Happen? perception arbitrage: 7 The Market Goes “No Bid” 7 Who is in worse Shape – US in – Perception: Bailouts stabilize the system and reduce volatility 2009 or Argentina in 2001? Reality: Bailouts increase long-term volatility/risk by creating 7 A comparison of public debt to moral hazard and subsidizing failure – whatever activities you revenue ratios during past crises subsidize and de-risk you will ultimately get increased production with some of those today. of, not less. 7 In the Category of You Know You Have Problem When… 8 In the Category of You Know You Have an Even Worse Problem When… 1
  3. 3. Summary (continued) – Perception: Government intervention will help maintain growth Reality: Increasing the size of government is reducing not improving our ability to create real growth. The idea that we must keep credit available to the state at any cost because only state spending can maintain growth while the private sector recovers borders on lunacy. Government spending is purely a transfer mechanism and typically destroys capital. Therefore increasing government spending at this time destroys capital exactly when it is needed the most to rebuild balance sheets thereby ensuring lower real growth rates in the future. – Perception: Private sector debt reduction/defaults make deflation our biggest risk – CPI shows that there is no inflation Reality: The absence of general price inflation being used as proof of the lack of inflation misses the much more subtle nature Contents Continued of inflation - inflation does not happen in the aggregate and newly created money and credit flows into certain assets/goods 9 Greece versus US first then only over time is spread throughout the economy. 9 China May Surpass US GDP by Monetary inflation has for many years been focused on risk 2027 assets rather than consumption items (it is consumptions items 10 More on Sovereign Defaults… that overwhelmingly drive the typical inflation measure such as 11 Bondholders Beware? CPI). 11 Unsustainable Public Sector Fiscal Path You can have an economy that is experiencing strongly 12 Cheerleaders Get Paid Better increasing and decreasing nominal prices at the same time as Than You Thought newly created money and credit rotates from sector to sector in 12 Fiscal Analysis – Reductions search of returns. Required in Virtually Every Country Of course, the heavily geared asset classes that were the 13 US Farmland Returns beneficiaries of the monetary expansion of the last decade – 13 IEA 2010 Energy Demand the financial sector, sovereigns, residential and commercial real Report estate come immediately to mind - should continue to suffer 14 World Energy Markets by Fuel ongoing solvency issues and pronounced nominal price declines Type as credit is re-allocated within the system but this is not the 15 Energy Factoids same as generalized deflation through-out the economy. 2
  4. 4. Summary (continued) Given this, it would seem a good assumption that much of the recently created money/credit will ultimately flow into a new part of the economy – likely those sectors whose fundamentals remain the most unimpaired and where gearing levels are lower. – Perception: Governments are not monetizing their debt Reality: Money is fungible so by buying bank assets and encouraging the risk free trade of investing in sovereign debt with excess bank reserves, central banks have used the captive and/or nationalized banking system as a vehicle to monetize government debt: – The Bank of England printed £200bn = 2009 UK government deficit. – The US Federal Reserve printed $1.25 trillion = 2009 US government deficit – ECB printing Euro 750 billion for Greek bailout = 2009 EU 27 government deficit In any event, I believe there will come a point when central banks will monetize government deficits much more openly. Logically the vast amounts of government debt rolling over the next years combined with already large and growing fiscal deficits will be the catalyst. In just one example, how can the US borrow an additional $10 trillion and rollover another $13 trillion in debt over next decade when the current money supply is only around $15 trillion? Even assuming that budget estimates are accurate – and many observers expect the total to be more like $20 trillion than $10 trillion – then is a failed US debt auction a possibility in the future? In the near term volatility will remain the order of the day as the economies of the west experience the clash of strong inflationary forces against the liquidation of decades of mal-investments playing out across many asset classes. Therefore, I continue to believe that capital preservation should be given the highest priority with an allocation to investments with returns linked to markets with generally favorable demographics, low national debt levels, high savings, and trade surpluses that can be expected to continue going forward (e.g. emerging economies and Asia in particular). Regards Stephen Johnston - Partner 3
  5. 5. Petrocapita Update (continued) the inflation lag In his book, “The Dying of Money” Jens Parssons to shore up the Euro and shift the blame for its discussed the concept of the “inflation lag”. The weakness to the financial markets rather than the idea is simple; the money supply often can increase profligate bailout of Greece. significantly over an extended period of time before inflation becomes apparent. We have experienced develoPed World has the debt Problem, almost 30 years of benign general price inflation Can you believe less so for the coupled with massive monetary base expansion emerging markets such that a large inflation gap has accumulated. When inflation begins to accelerate it may be Chart 2 shows an IMF forecast for government debt commensurately massive and lengthy as the gap is levels of developed and developing countries. The closed – see chart 1. emerging sovereigns’ debt levels are much lower and stable while their more “developed” brethrens’ die leerverkäufer sind kaPutt levels are much higher and accelerating – years of unrestrained government spending coming home The German breed of short-seller (“Leerverkäufer”) is to roost? As Paul Kedrosky recently quipped are set to become extinct. In the spirit of the “battle of the developed economies called that “because they the politicians against the markets” Germany has have developed a fully metastasized case of societally banned naked short-selling. The message is clear, terminal debt?”. naked derivatives trades where the underlying is the Euro will not be tolerated - a desperate attempt Chart 2: general government gross debt ratios Chart 1: mZm stoCk, PPi, CPi (% gdP, 2009 PPP-gdP Weighted average) MZMN5, 1960-04=100 120 Index PPIACO, 1960-04=100 G-20 Advanced CPIAUCNS, 1960-04=100 3,600 100 All Advanced 3,200 Low Income 2,800 80 2,400 2,000 “Inflation Lag” 60 1,600 G-20 Emerging 1,200 40 Emerging 800 (broad sample) 400 20 0 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: St Louis Federal Reserve Source: DB Global Markets Research, IMF 4
  6. 6. Petrocapita Update (continued) ‘Some horrendouS KeyneSian/monetariSt nightmare’ fantasyland ‘efficiency gains’ are the latest evidence Royal Bank of Scotland strategist Bob Janjuah’s that policymakers EVERYWHERE have no appetite recent research note has a somewhat dark mood to be brave, to be strong and to do the right thing. It to say the least: “I had assumed, after doing seems that it is clearly too painful to do anything else. what it took in late 08 and early 09 to avoid global Instead, policymakers EVERYWHERE seem to have depression and systemic financial system collapse, decided that the only way out of the hole is MORE that policymakers & their buddies would see the light DEBT, MORE DEBASEMENT, MORE BAILOUTS, and realise that the only path to long term success ugly INFLATION and/or even uglier STAGFLATION, for the problem economies (US, UK, most of Europe, FAKE AUSTERITY, ZERO STRUCTURAL ECONOMIC Japan, etc) would be a period of Austerity, Balance REFORM, & MINIMAL REGULATORY REFORM. Sheet repair, Deflation, Real Structural Economic We are trapped in some horrendous Keynesian/ reform and Serious Financial System/Accounting monetarist nightmare, where policymakers, aided/ regulation/reform. This path is NOT the easy path abetted/advised by their buddies in the media, in near term, but it is the ONLY path for ensuring the lobbyist cabal and in financial system, have YET the long term health and success of the problem AGAIN decided to go down the route which merely economies, as well as ultimately the ONLY path which delays the problem/pushes it down the road, but will both successfully iron out the grotesque global which virtually guarantees that when the NEXT bubble imbalances and help ensure the long term success collapses (I assume it will be the Global Government of the global economy. SADLY, during my period Debt/Bond Bubble and/or the Global Fiat Money/ of reflection, I have come round to the view that we Paper Money/FX Bubble), there is NO pleasant way have missed this golden opportunity. What instead I back.” am seeing is a desperate attempt to re-write history (‘there was no bubble’, ‘rates too low for too long a glimPse into the finanCial hell of had nothing to do with it’, ‘it’s all just the fault of a stagflation bunch of greedy traders’, etc etc) AND at the same time it is clear global policymakers and their buddies, Royal Bank of Scotland strategist Alan Ruskin whilst jaw-boning us about ‘exit’ and ‘austerity/ recently conducted a thought experiment on a US fiscal repair’, simply do NOT mean what they are sovereign debt crisis. According to Rushkin, only saying – in other worlds, they are talking ‘responsibly’ food commodities would be worth owning. “Now a but are acting IMHO in a reckless and irresponsible US Treasury crisis should also never have to extend manner. And in my book actions ALWAYS speaker to default, as long as the Fed is willing to buy US far more clearly and far louder than (cheap) talk. The Treasury debt, and deliver the haircuts to investors Greece bail-out, the goings on at the IMF involving through inflation rather than direct restructuring – the huge build-up of ‘new bail-out’ reserves, and which may be preferable for reputational interests. all the talk in the UK about fiscal repair based on Unfortunately the inflation route is still desperately 5
  7. 7. Petrocapita Update (continued) painful, not least because it drives up nominal on discovering that such was the financial system yields and delivers the pain incrementally through distress it was unable to, it just carried on regardless. bond and currency losses, rather than all upfront In the US, the Fed printed $1.25 trillion to monetise as a restructuring. Such bond losses are indicative the problematic mortgage market. It also said it was of how a fiscal funding crisis quickly ends up as a going to sterilise the intervention, but like the BoE it monetary policy crisis, and a collapse in central bank soon found it couldn’t, and like the BoE continued control across the curve. Although this all feels like anyway because the alternative financial meltdown jumping deep into the land of the hypothetical, the scenario was too scary to contemplate. Today, above scenario is not too far removed from the late the ECB is buying insolvent Eurozone government 1970s period of stagflation. I have gone back a good debt which it is promising to sterilise. Yet they face deal further, to the start of the 20th century to see the same stark calculus faced by their Anglo-Saxon how assets coped with stagflation (a relatively rare cousins in 2008. You can only worry about the phenomenon) which would be the likely backdrop to economy’s ‘price stability’ if the economy hasn’t (or outcrop of) a US sovereign crisis. The conclusions already melted down! So here’s my prediction: they are not pretty. As feared there have been very few won’t sterilise, and the program will expand. places to hide outside commodities when US growth Most economists seem to think that QE puts us is very soft and inflation is above a 5% threshold. in uncharted waters. It doesn’t. Printing money to Sell, equities, be a big seller of BAA then AAA bonds finance government expenditure is a very well trodden and yes buy FOOD commodities. Food commodities path which is as old as money itself: persistent have been up as much as 30% y/y in years since monetisation causes inflation. Of course the current 1900 when US per capita income was negative monetisation need not be persistent. Central banks and inflation is above 5%, perhaps because these can theoretically just stop it at any time. conditions are also accompanied by energy shocks or war, that are among the other darkest channels to But with government balance sheets in such a mess financial blight.’ across the developed world (even with yields at historically unprecedentedly low levels), government Qe uPdate – When is the sterlisation funding crises are likely to be a recurring theme in going to haPPen? the future. Since banks hold so much “risk free” government debt, those funding crises point towards According the SocGen anlalyst Dylan Grice “In 2009, more banking crises which point towards more the BoE printed £200bn, thus completely financing money printing. When do they stop? When can they the UK government deficit. It can’t have felt good stop? But what does it all mean? The question to about doing it but since the alternative scenario my mind isn’t whether or not inflation will accelerate was so scary– financial meltdown and possibly from here. If government balance sheets are in as big IMF support– it held its nose and did it anyway. It a mess as I think they are, inflation is inevitable.” said it was going to sterilise the intervention, but 6
  8. 8. Petrocapita Update (continued) the market goes “no bid” Who is in Worse shaPe – us in 2009 or argentina in 2001? Various high frequency trading systems or fat finger explanations notwithstanding here are two A comparison of public debt to revenue ratios during experienced market commentators with much simpler past crises with some of those today. ideas about how markets can fall unexpectedly and rapidly – simply put an absence of buyers. Chart 3 John Kenneth Galbraith described the crash of 1929 as follows: “Of all the mysteries of the stock Historical public debt/revenue ratios during selected defaults Selected ratios today 18 exchange there is none so impenetrable as why there 16 should be a buyer for everyone who seeks to sell. 14 12 October 24, 1929 showed that what is mysterious is 10 not inevitable. Often there were no buyers, and only 8 after wide vertical declines could anyone be induced 6 4 to bid ... Repeatedly and in many issues there was 2 a plethora of selling orders and no buyers at all. The 0 Mexico, 1827 Spain, 1877 Argentina, 1890 Germany, 1932 China, 1939 Turkey, 1978 Mexico, 1962 Brazil, 1963 Philippines, 1983 South Africa, 1985 Russia, 1998 Pakistan, 1998 Argentina, 2001 Greece, 2009 Spain, 2009 Japan, 2009 US, 2009 stock of White Sewing Machine Company, which had reached a high of 48 in the months preceding, had closed at 11 on the night before. During the day someone had the happy idea of entering a bid for a block of stock at a dollar a share. In the absence of Source: SG Cross Asset Research, Reinhart and Rogoff 2009 any other bid he got it.” John Kenneth Galbraith, 1955, The Great Crash Richard Russell described the 1973-74 crash as in the Category of you knoW you have follows: “I started accumulating stocks in December Problem When… of ‘74 and January of ‘75. One stock that I wanted to buy was General Cinema, which was selling at a low Even the US military thinks the US budget deficit is of 10. On a whim I told my broker to put in an order too big. To quote a recent research paper by the for 500 GCN at 5. My broker said, ‘Look, Dick, the Army “Although these fiscal imbalances have been price is 10, you’re putting in a crazy bid.’ I said ‘Try severely aggravated by the recent financial crisis and it.’ Evidently, some frightened investor put in an order attendant global economic downturn, the financial to ‘sell GCN at the market’ and my bid was the only picture has long term components which indicate bid. I got the stock at 5.” Richard Russell, 1999, Dow that even a return to relatively high levels of economic Theory Letters growth will not be enough to right the financial 7
  9. 9. Petrocapita Update (continued) picture. The near collapse of financial markets Interest ate up 44% of the British Government budget and slow or negative economic activity has seen during the interwar years 1919-1939, inhibiting its U.S. Government outlays grow in order to support ability to rearm against a resurgent Germany. Unless troubled banks and financial institutions, and to current trends are reversed, the U.S. will face similar cushion the wider population from the worst effects challenges, anticipating an ever-growing percentage of the slowdown. These unfunded liabilities are a of the U.S. government budget going to pay interest reflection of an aging U.S. Baby-Boom population on the money borrowed to finance our deficit increasing the number of those receiving social spending.” program benefits, primarily Social Security, Medicare, and Medicaid, versus the underlying working in the Category of you knoW you have an population that pays to support these programs. even Worse Problem When… Rising debt and deficit financing of government According to the US Army “A severe energy crunch operations will require ever-larger portions of is inevitable”. In a recent report Army analysts government outlays for interest payments to service wrote “To meet even the conservative growth rates the debt. Indeed, if current trends continue, the U.S. global energy production would need to rise by 1.3% will be transferring approximately seven percent of per year going forward. By the 2030s, demand its total economic output abroad simply to service its is estimated to be nearly 50% greater than today foreign debt. Interest payments are projected to grow and even assuming more effective conservation dramatically, further exacerbated by recent efforts to measures, the world would need to add roughly stabilize and stimulate the economy, far outstripping the equivalent of Saudi Arabia’s current energy the current tax base shown by the black line. Interest production every seven years (1.4 MBD per year). payments, when combined with the growth of Social The discovery rate for new petroleum and gas Security and health care, will crowd out spending fields over the past two decades (with the possible for everything else the government does, including exception of Brazil) provides little reason for optimism National Defense. The foregoing issues of trade that future efforts will find major new fields. imbalance and government debt have historic precedents that bode ill for future force planners. At present, investment in oil production is only Habsburg Spain defaulted on its debt some 14 times beginning to pick up, with the result that production in 150 years and was staggered by high inflation could reach a prolonged plateau. By 2030, the until its overseas empire collapsed. Bourbon France world will require production of 118 MBD, but energy became so beset by debt due to its many wars and producers may only be producing 100 MBD unless extravagances that by 1788 the contributing social there are major changes in current investment and stresses resulted in its overthrow by revolution. drilling capacity. 8
  10. 10. Petrocapita Update (continued) By 2012, surplus oil production capacity could greeCe versus us entirely disappear, and as early as 2015, the shortfall in output could reach nearly 10 MBD. In the last 42 years the US Federal Government has run a deficit 88% of the time and deficits of 9%, 7% A severe energy crunch is inevitable without a and 6% are expected over the next 3 years. Greece, massive expansion of production and refining the current poster boy for profligate government capacity. While it is difficult to predict precisely spending, has had average deficits of 7% of GDP what economic, political, and strategic effects such over the last 5 years. a shortfall might produce, it surely would reduce the prospects for growth in both the developing and China may surPass us gdP by 2027 developed worlds. Such an economic slowdown would exacerbate other unresolved tensions, push Goldman Sachs is predicting that the GDP of China fragile and failing states further down the path toward will surpass the US in 17 years, 13 years earlier than collapse, and perhaps have serious economic impact their previous prediction. on both China and India. At best, it would lead to periods of harsh economic adjustment.” Emphasis mine Chart 4: us defiCit/surPlus Chart 5: gdP ProjeCtions briCs v West as PerCent gdP ($billions) 70,000 4% 60,000 2% 50,000 0% -2% 40,000 “Il Sorpasso”: 2027 (previously 2040) -4% 30,000 -6% 20,000 -8% 10,000 -10% 2006 2011 2016 2021 2026 2031 2036 2041 2046 -12% 1975 1985 1995 2005 Brazil Russia United Kingdom China Germany United States Source: Bloomberg India Japan Source: Goldman Sachs 9
  11. 11. Petrocapita Update (continued) more on sovereign defaults… Chart 6: Periods of banking Crises, The lessons of financial history, inflation and outright default and inflation by Country sovereign defaults as distilled by Niall Ferguson author of “The Ascent of Money”: Since independence or 1800 Since 1800* Share of Share of Total Share Share Number of What do governments not do with world war size years in a years in number of of years of years hyperinfla- debt burdens? banking default or defaults in which in which tion years – Slash expenditure on entitlements crisis reschedul- and inflation inflation ing reschedul- exceeded exceeded – Reduce marginal tax rates on income and ings 20% 40% corporate profits to stimulate growth Austria 2 17 7 21 12 2 – Raise taxes on consumption to reduce deficits Belgium 7 10 7 – Grow their way out without defaulting or depreciating their currencies Denmark 7 2 1 Finland 9 6 3 What do governments usually do with world war size Germany 6 13 8 10 4 2 debt burdens? Greece 4 51 5 13 5 4 – Oblige central bank and commercial banks to Hungary 7 31 7 16 4 2 hold government debt – Restrict overseas investment by firms and citizens Italy 9 3 1 11 6 – Default on commitments to politically weak Netherlands 2 6 1 1 groups and foreign creditors Norway 16 5 2 – Condemn bond investors to negative real interest Poland 6 33 3 28 17 2 rates Portugal 2 11 6 10 4 What are the geopolitical consequences of crises of Spain 8 24 13 4 1 public finance? Source: Reinhart and Rogoff (2009) Sweden 5 2 – In fiscal stabilizations, discretionary military United 9 2 spending is usually the first casualty Kingdom – In cases of default on external debt, conflicts with Source: Reinhart and Rogoff (2009) creditors can arise – In cases of currency depreciation, reserve currency status can be lost to a rising rival 10
  12. 12. Petrocapita Update (continued) bondholders beWare? and reduce their adverse consequences for long- term growth and monetary stability... It follows that Chart 7 represents the real annual returns on UK and the fiscal problems currently faced by industrial US bonds, 1900-1995. Are we heading into another countries need to be tackled relatively soon and period of negative real returns to bonds? unsustainable PubliC seCtor fisCal Path Chart 8: debt/gdP ProjeCtions “Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities Portugal Ireland 300 400 in a number of industrial countries is unsustainable. 250 300 Drastic measures are necessary...” That is a 200 direct quote from a recent study by the Bank of 150 200 International Settlements (“BIS”). The study looks at 100 100 public sector fiscal policy and public debt in a number 50 of developed countries (see chart 8) and concludes: 80 90 00 10 20 30 40 0 80 90 00 10 20 30 40 0 “Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities Greece Spain 500 400 in a number of industrial countries is unsustainable. 400 Drastic measures are necessary to check the rapid 300 growth of current and future liabilities of governments 300 200 200 100 100 0 0 Chart 7 80 90 00 10 20 30 40 80 90 00 10 20 30 40 12 United Kingdom United States 600 500 10 500 400 8 400 6 300 300 4 200 200 2 100 100 0 0 1900-1909 1910-1919 1920-1929 1930-1939 1940-1949 1950-1959 1960-1969 1970-1979 1980-1989 1990-1999 0 -2 80 90 00 10 20 30 40 80 90 00 10 20 30 40 -4 -6 Baseline scenario -8 Small gradual adjustment -10 Small gradual adjustment with age related spending held constant UK US Source: GFD Source: BIS 11
  13. 13. Petrocapita Update (continued) resolutely. Failure to do so will raise the chance of demonstrate a marked inability (unwillingness?) to an unexpected and abrupt rise in government bond forecast downturns. Not an unsurprising institutional yields at medium and long maturities, which would bias in a sector that is dependent on selling securities put the nascent economic recovery at risk. It will also to the unsuspecting public regardless of the quality or complicate the task of central banks in controlling economic conditions. inflation in the immediate future and might ultimately threaten the credibility of present monetary policy fisCal analysis – reduCtions reQuired in arrangements.” virtually every Country Cheerleaders get Paid better than you Assuming governments want merely to stabilize thought debt levels as a percentage of GDP the numbers in chart 10 represent the contraction in fiscal spending According to a study by McKinsey, Wall Street equity necessary between 2010 and 2030 as a percentage analysts have on average, overestimated S&P 500 of GDP. Not a promising picture given the virtual earnings by two times for almost 30 years and inability of governments to undertake sustained reductions in outlays in the face of political pressure from the voters and the current low interest rate environment. Chart 9: reality versus Wall street “analysis” Long-term Forecast1 average % Actual2 Chart 10 18 16 14 14 12 12 10 10 8 6 8 4 6 2 0 4 -2 2 1985-90 1987-92 1989-94 1991-96 1993-98 1995-00 1997-02 1999-04 2001-06 2003-08 2004-09 0 Analyst’s 5-year forecast for long-term consensus earnings-per-share Portugal 1 Korea Switzerland Norway Iceland New Zealand Sweden Israel Hong Kong SAR Czech Republic Germany Slovenia Italy Slovak Republic Denmark Canada Finland Austria Belgium Singapore Austria Netherlands France United Kingdom Greece Spain Ireland United States Japan -2 (EPS) growth rate. Our conclusions are same for growth based on year- over-year earnings estimates for 3 years. -4 2 Actual compound annual growth rate (CAGR) of EPS; 2009 data are not yet available, figures represent consensus estimate as of Nov 2009. -6 Source: HBR/McKinsey Source: IMF 12
  14. 14. Petrocapita Update (continued) us farmland returns economic growth paths that were anticipated before the recession began. Institutions that have invested in US farmland have earned a return of 11.2% since 1992, with no down The most rapid growth in energy demand from 2007 years. to 2035 occurs in nations outside the Organization for Economic Cooperation and Development (non- iea 2010 energy demand rePort OECD nations). Total non-OECD energy consumption increases by 84 percent in the Reference case, “The global economic recession that began in 2007 compared with a 14-percent increase in energy use and continued into 2009 has had a profound impact among the OECD countries. Strong long-term growth on world energy demand in the near term. Total world in gross domestic product (GDP) in the emerging marketed energy consumption contracted by 1.2 economies of non-OECD countries drives the fast- percent in 2008 and by an estimated 2.2 percent in paced growth in energy demand. In all the non-OECD 2009, as manufacturing and consumer demand for regions combined, economic activity—as measured goods and services declined. Although the recession by GDP in purchasing power parity terms—increases appears to have ended, the pace of recovery has by 4.4 percent per year on average, compared been uneven so far, with China and India leading and with an average of 2.0 percent per year for OECD Japan and the European Union member countries countries. lagging. In the Reference case, as the economic situation improves, most nations return to the The IEO2010 Reference case projects increased world consumption of marketed energy from all fuel sources over the 2007-2035 projection period (Chart Chart 11 12) Fossil fuels (liquid fuels and other petroleum, natural gas, and coal) are expected to continue 35% 6.3% 1992-2009 supplying much of the energy used worldwide. annualized Yearly Returns, NCREIF Farmland Index returns Although liquid fuels remain the largest source of 30% energy, the liquids share of world marketed energy Russell 3,000 25% consumption falls from 35 percent in 2007 to 30 Lehman percent in 2035, as projected high world oil prices 6.3% Aggregate 20% 6.3% lead many energy users to switch away from liquid 6.3% 6.3% Farmland fuels when feasible. In the Reference case, the use 15% of liquids grows modestly or declines in all end-use 6.3% sectors except transportation, where in the absence 10% 6.3% 6.3% 6.3% 6.3% 6.3% 6.3% 6.3% 6.3% 6.3% 6.3% 6.3% of significant technological advances liquids continue 6.3% 6.3% 6.3% 5% to provide much of the energy consumed. 6.3% 0% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 13
  15. 15. Petrocapita Update (continued) Average oil prices increased strongly from 2003 to strengthen thereafter as the world economies recover mid-July 2008, when prices collapsed as a result of fully from the effects of the recession. In the IEO2010 concerns about the deepening recession. In 2009, Reference case, the price of light sweet crude oil in oil prices trended upward throughout the year, from the United States (in real 2008 dollars) rises from $79 about $42 per barrel in January to $74 per barrel in per barrel in 2010 to $108 per barrel in 2020 and December. Oil prices have been especially sensitive $133 per barrel in 2035. to demand expectations, with producers, consumers, and traders continually looking for an indication of World energy markets by fuel tyPe possible recovery in world economic growth and a likely corresponding increase in oil demand. On the Liquids remain the world’s largest energy source supply side, OPEC’s above-average compliance throughout the IEO2010 Reference case projection, to agreed-upon production targets increased the given their importance in the transportation and group’s spare capacity to roughly 5 million barrels per industrial end-use sectors. World use of liquids and day in 2009. Further, many of the non-OPEC projects other petroleum grows from 86.1 million barrels that were delayed during the price slump in the per day in 2007 to 92.1 million barrels per day in second half of 2008 have not yet been revived. 2020, 103.9 million barrels per day in 2030, and 110.6 million barrels per day in 2035. On a global After 2 years of declining demand, world liquids basis, liquids consumption remains flat in the consumption is expected to increase in 2010 and buildings sector, increases modestly in the industrial sector, but declines in the electric power sector as electricity generators react to rising world oil prices Chart 12 by switching to alternative fuels whenever possible. In the transportation sector, despite rising prices, use History Projections of liquid fuels increases by an average of 1.3 percent 250 per year, or 45 percent overall from 2007 to 2035. 200 To meet the increase in world demand in the Liquids Reference case, liquids production (including both 150 conventional and unconventional liquid supplies) Coal increases by a total of 25.8 million barrels per day Natural Gas 100 from 2007 to 2035. The Reference case assumes that OPEC countries will invest in incremental Renewables 50 production capacity in order to maintain a share Nuclear of approximately 40 percent of total world liquids 0 production through 2035, consistent with their 1990 2000 2007 2015 2025 2035 share over the past 15 years. Increasing volumes of Source: IEA 2010 conventional liquids (crude oil and lease condensate, 14
  16. 16. Petrocapita Update (continued) natural gas plant liquids, and refinery gain) from sands from Canada and biofuels, largely from Brazil OPEC producers contribute 11.5 million barrels per and the United States, are the largest components day to the total increase in world liquids production, of future unconventional production in the IEO2010 and conventional supplies from non-OPEC countries Reference case, providing a combined 70 percent of add another 4.8 million barrels per day (Chart 13). the increment in total unconventional supply over the projection period.” Unconventional resources (including oil sands, extra- heavy oil, biofuels, coal-to-liquids, gas-to-liquids, and energy faCtoids shale oil) from both OPEC and non-OPEC sources grow on average by 4.9 percent per year over the According to the IEA: projection period. Sustained high oil prices allow – China is expected to consume 11% of global unconventional resources to become economically oil production in 2010 competitive, particularly when geopolitical or – China accounted for 45% of the growth in other “above ground” constraints limit access to global oil demand over the past decade prospective conventional resources. World production of unconventional liquid fuels, which totaled only 3.4 million barrels per day in 2007, increases to 12.9 million barrels per day and accounts for 12 percent of total world liquids supply in 2035. Oil Chart 13 History Projections 125 100 Total 75 Non-OPEC conventional 50 OPEC conventional 25 Unconventional 0 1990 2000 2007 2015 2025 2035 Source: IEA 2010 15
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